The effects of the Euro Zone Crisis

The effects of the Euro Zone Crisis

Name: MENG LU

Institution:  LEICESTER UNIVERSITY

Date: 2012.12.29

Words:2997

The effects of the Euro Zone Crisis

Over the past two years, the Euro zone has been going through the worrying discussion regarding how to handle the emerging home grown crisis also known as the Euro zone crisis, which threatens to hurt the European economy. The Euro zone financial systems in recent times have observed three challenges that pose a major threat to the viability of the European Union currency. The crises that are faced by the Euro zone include the banking crisis, which involves the banking sector being undercapitalized and facing liquidity problems (Shambaugh, 2012). The Euro area suffers a major blow. The banks have a restrained interbank liquidity, their future losses in most cases are blurred and uncertain plus they face a shortfall in their capital allocation (Dadush, 2010). The sovereign debt crisis is another problem facing the Euro zones. This involves several countries that have been faced with the increasing bond yields and in the process; they try and challenge the funding themselves and in the end, one country ends up not paying their debts in full (Dadush, 2012). The other crisis affecting the Euro zone is regarding growth and development (Anand, Gupta and Daah, 2012).

This last crisis is the one primarily talking about the level and distribution of growth within the Euro area. The current account discrepancies affecting the peripheral economies have contributed majorly to the Euro zone crisis (Shambaugh, 2012). This means there are certain indicators of credit booming with others portraying a growing difference inside the cutthroat nations within the Euro area. The gaps created grew over a period of ten years and in the process, becoming hard to quickly reverse with no significant changes regarding the exchange rates across member states (Shambaugh, 2012). Such development interrelates in one way or the other and they affect the economy and to a greater extent, the future of the Euro currency in the Euro zones. Managing such economies in the affected currency zones together with the political pressure emanating are the major contributors towards the crisis rather than the currency. The political pressure comes about because there are different constituents that are moving with varying rates, have different fiscal capacities and the different debt reports. The problem arises because all these are tied down to one single currency, which has been adopted by other nations like Greece, Italy, Portugal, Ireland and Spain (Dadush, 2010). This paper focuses on the broad achievement being carried out relating to the Euro zone crisis and the above named countries.

The banking crisis in the Euro zone

The banking crisis in the Euro area has been broad just like their American counterparts. The banks in the area have a high number of total assets especially between 2007. This meant that there were certain discrepancies concerning the data comparability (Dadush, 2010). Due to their large banking system sizes, the majority of organizations relies fully on the financial institutions for monetary support thus making the banking industry a very important industry (Anand, Gupta and Daah, 2012). Banks in most cases fund their operations by means of the short term liabilities they end up getting (Dadush, 2012). These liabilities are withdrawn in the form of demand deposits, which are then invested by the banks in making securities or in the form of loans. In case a bank has a large number of short term funds that are withdrawn constantly, then a problem arises because the bank becomes vulnerable and weakened by the fact that such short term deposits and withdrawals attract a large number of people looking for short term credits and only a handful may end up paying back (Shambaugh, 2012).

A bank’s assets become worthless and insolvent when their loans and investments are less than the money they owe their depositors and the other creditors too (Shambaugh, 2012). Fear makes depositors terminate their funds from a bank. Banks in most cases may not be accountable for their financial earnings thus their depositors fear losing in the process. A great number of short term withdrawals can make even the most profitable bank in the world collapse because the bank cannot meet their high funding at an instant. One main reason for this is the fact that their assets are held up in other forms such as loans and hard to settle securities (Shambaugh, 2012).

Liquidity and solvency end up comprising a bank’s list of problems. It is either the bank cannot pay up their debts because their assets are insufficient or the banks cannot raise the stipulated amount of money within the given time frame (Shambaugh, 2012). The central bank becomes the main donor for a bank that has been faced by the liquidity crisis. In case a bank truly becomes insolvent, it may need to cut down the losses, which must be taken either by the creditors, the equity investors of a bank, the taxpayers, or some form of accepted combination (Shambaugh, 2012). If there is a possibility of an insolvency threat looming, the threat may end up providing a cushion against the expected losses because it would guarantee solvency in case the bank crushes (Shambaugh, 2012). The equity holders still have to suffer heavily due to the imposed losses because they have shares in the banking sector, which have already been diluted. Another reason is the fact that of the possibility of taxpayer’s costs being diluted (Shambaugh, 2012).

The creation of the European Banking Authority has centralized some functions, but supervision and especially the fiscal support are still at the national level. In the Euro zones and globally, the global banking supervision is a problem shared by the national activities. These activities include the free flow of money across and within the borders of the existing member states. Creating a central monetary authority ensures a great deal of the money is under supervision. In Europe, the European Banking Authority is the body mandated to supervise financial support both at centralized and national levels (Shambaugh, 2012). The terms of liquidity, in most cases, is an activity that is conducted by the central bank as it is only the central bank that can instantly come up with as much liquidity as needed. This assumption thus leaves the role of liquidity provision to banks in the ECB, which is a Euro area wide institution. The only limiting factor is that the ECB has no legal responsibility to serve as the lender of last resort. It can operate the same as the central bank but is not officially charged with that kind of responsibility (Obstfeld, 1998).

The liquidity problem in 2007 created a major disaster in the American and European financial institutions. The American price houses’ assets became diluted since a large number of the mortgage values became questionable (Shambaugh, 2012). This made banks borrowing money difficult owing to the fact that their assets portrayed certain levels of discrepancies. One discrepancy was the fact that these financial institutions encountered financial stress with a huge difference between their short term payment rates of the borrowed loans (Shambaugh, 2012). This made the nation’s central banks to step in and solve the looming financial crisis. The first way they acted was by cutting down the rates they charged the banks used to borrow. The second way they saved the banks were by increasing the amount of assets these banks had on their financial books and increasing the quantity of mortgages they made to the banking sector (Shambaugh, 2012). The third way the central banks came to rescue the Euro financial banking crisis was by arranging a variety of financial liquidity swaps. The Federal Reserve provided funds in the form of dollars to the central banks of several nations to act as collateral. This aided such nations especially the Euro zone nationalities that had some form of difficulties in accessing the dollar funds. This shortage came about because such financial institutions had resulted in borrowing short term dollars and held illiquid American assets (Shambaugh, 2012). This financial backup by the Federal Reserve ensured the ECB and other non American central banks would be able to provide financial support in the form of dollars directly to the needy banks. The sovereign debt crisis and the banking crisis are related in one way or the other. Due to the fact that the banking crisis had not been settled, solvency problems were triggered by the liquidity problems, which acted as a catalyst. A chain of bailouts and agreements was a necessity by the Euro area banks in order to continue to struggle with undercapitalization

The Sovereign Debt Crisis

The sovereign debt crisis has suffered several phases in the Euro zone. One phase was when the European government bonds sky rocketed to very high levels (Shambaugh, 2012). Different investors have different interest rates they demand especially with respect to the bonds from two different nations. One reason for this is in terms of currency. In case one currency is stronger than the other one and is expected to strengthen the other currency, the stronger currency assets have a high value that is worth every penny for a long period of time (Shambaugh, 2012). Numerous investors might be willing to hold on to the strong asset even if the said asset would be trading a lower interest rate. On the other hand, the investors may worry that the government will end up defaulting, which in simple terms means the government is likely to pay a higher rate of  interest so as to compensate its investors for the risk (Shambaugh, 2012).

Interest rates within the European region portrayed wider gaps before the introduction of the Euro. This meant that the Euro had a huge significance to the European community. Until the Euro zone crisis the interest rate gaps were very minimal. Countries such as Greece joined the Euro recently due to the fact that all Euro countries became neutral from defaulting (Shambaugh, 2012). During the first years of the Euro crisis, the spreads were relatively low but spread as the years progressed. Greece was affected in 2010 by this crisis as it spread to other countries. By definition, default means that an affected country cannot be able to pay back its borrowed debts (Shambaugh, 2012). The Euro sovereign debt predicament is usually viewed more often than not by means of the financial extravagance, which is heightened by the fact that Greece was the first country to have experienced this looming crisis. Greece is known for its extravagant spending and their inaccurate government finances that have been reported in recent times (Shambaugh, 2012). Irresponsible fiscal procedures were the main cause of this crisis and the main solution to curbing this problem was by having stringent measures in place especially regarding the financial expenditures. The international monetary fund acted as a subsidiary reserve in case such nations could not be able to meet up their short term financial budgets (Shambaugh, 2012). In most cases, a bank crisis acts the same as a sovereign crisis. This is because a nation that can be able to fund its financial needs and at low interest rates is said to be solvent. In case that same country is forced to pay a high interest rate, it is said to be insolvent. This insolvency can still occur even if the said country’s primary budgets are balanced accordingly (Shambaugh, 2012).

The Euro Area Growth Crisis

Most nations in the world including the Euro zone emerged a fresh from the 2009 recession, which saw the growth rates improving. The Euro area appeared to have a tremendous growth as compared to other nations like America or Asia. Sentiments within the European nations began to vary. Germany as a nation had a more negative sentiment regarding the Euro zone crisis as compared to the other member states including Spain, Portugal Greece and Italy among others (Shambaugh, 2012). These sentiments included both the end user and big business self-assurance reported by the European Commission. When the crisis was at its peak, Germany changed its sentiments into a more rebounded statement during the 2009 and 2010 era (Shambaugh, 2012). By the end of 2010, Germany’s sentiments became positive and re-assuring due to the fact that they had improved beyond the Euro zone crisis (Shambaugh, 2012). This positive attitude became widespread all over the Euro zone.

Unemployment was one major factor that resulted in Germany’s negative attitude. During the mid 2010 period, the employment rate in Germany as well as other northern tier nations went below the expected mark. The Euro zone had an average of 10 percent unemployment rate, which continued to rise even after the recession period had come to an end (Shambaugh, 2012). The Euro unemployment rate in the member states, GIPSI’s continued to rise even by the fourth quarter of 2011. This gave birth to new unemployment rates of 10.7 percent. The rate of unemployment includes both the unemployed youth who average nearly 50 percent together with the elderly (Shambaugh, 2012).

The growth imbalance in the Euro zone is often described as an imminent problem regarding the current imbalances that have not been accounted for within the Euro area (Wolf, 2011). The large existing account deficits preceding to the crisis and the overall debt build up constitute the major problem that affects Euro zone member states (Wolf, 2012). The current growth crisis and the current account discrepancies are linked together.  In addition, the investment inflows have helped to increase prices, and thus dipping the competitiveness of the borrowing nation states. Furthermore, as the prices amplify in the nonessential countries, it means their real interest rates have fallen compared to the further Euro nations therefore, leading to more borrowing (Lane, 2006). Improved exports or in other cases the reduced imports could add to the Gross Domestic Product if one is given how far the financial systems are from complete employment.

In addition, the imbalances ahead of the emergency tinted the buildup of debit, which in recent times requires painful deleveraging. Blanchard and Giavazzi (2002) argued that the existing account deficits that are growing in recent times may not present a problem within the Euro area since they may be a simple representation of the poorer countries that have an elevated projected growth rate, which helps in boosting their rates of consumption in the newly unified market. According to Obstfeld (2012), more policy makers ought to try and remain cautious regarding the current account deficits especially within the currency unions. This is because after mo.............